Tax planning can be complex. It must balance tax efficiency with all other elements of financial planning required to meet a company’s commercial objectives. Most importantly, tax planning and tax structuring strategies need to withstand the scrutiny of a taxing authority.

Given the complexities of today’s tax laws, uncertainty may exist despite careful planning. An unexpected adverse tax outcome may significantly compromise the financial value of a transaction, investment, or tax planning strategy.

For deal participants, tax insurance can offer a solution. And while it has been around since the 1990s, it has recently become a more commonly used corporate risk management tool that taxpayers are just starting to learn to use effectively.

What Is Tax Insurance?

Words and phrases like “tax” and “tax liability” often prompt fear and panic. The thought of getting it wrong, resulting in an unanticipated payment to a taxing authority, can make C-suite executives, deal teams, private equity investors, and risk managers break into a cold sweat.

Tax insurance can provide valuable peace of mind for these stakeholders and protect taxpayers in the event an investment or tax position fails to qualify for the intended tax treatment following a successful challenge by a taxing authority. It can also serve a public policy objective by ensuring the ability to satisfy tax obligations that may be established at a later date.

Tax insurance is a cost-effective risk mitigation tool used to transfer a known tax risk from the taxpayer to an insurer. Each policy is bespoke and may be used to address a wide range of issues in the context of complex mergers and acquisition transactions, internal restructurings, balance sheet risk mitigation, and tax credit investments.

The key benefit of tax insurance—which is specifically mentioned as a preferred risk mitigation tool in several IRS revenue procedures—is that it can provide certainty that a particular tax transaction will have its intended effect. Tax insurance can also—

• ease merger and acquisition (M&A) transaction negotiations where the parties can’t agree on who should bear the risk of a potential tax exposure in the target, or a preacquisition restructure,
• enable a potentially “clean exit” for sellers,
• provide coverage for known tax issues excluded from representation and warranty (R&W) insurance policies, which generally cover unknown issues,
• provide assurance when tax laws and guidance on a particular tax issue are unclear and a private letter ruling is unavailable or not conducive to deal timing,
• enhance access to capital by replacing or backstopping tax indemnities and removing the need for escrows, and
• facilitate financing of a renewable energy project by supplementing a developer or sponsor’s tax indemnity and ensuring tax credit eligibility under the law.

It’s important to remember that tax insurance is intended to cover known tax risks. It’s most effective in circumstances where there’s a supportable position that the risk of exposure is low but the potential financial consequence of an adverse ruling could be significant—in other words, low likelihood but high severity. And it can be useful in several situations.

Mergers and Acquisitions

Tax insurance provides coverage for losses for known tax risks that may be contested subsequent to an acquisition’s closing. Oftentimes, tax insurance acts as a supplement by covering known tax exposures carved out of an R&W policy, and it can be procured by a buyer or a seller.

A tax policy can—

• provide recourse for the buyer when there’s no seller tax indemnity,
• eliminate seller post-closing tax risk,
• remove impediments to closing where request for relief or a ruling from the IRS isn’t available prior to signing, and
• lock in future tax benefits built into the purchase price.

For a seller, a tax insurance policy can—

• reduce escrows or contingencies, thereby enabling distributions of sale proceeds;
• attract best offers by maximizing indemnifications; and
• protect passive sellers.

Common areas of coverage include the following:

• IRC section 355 spinoffs.
• IRC section 382 “change of control” issues.
• Taxation of gains on disposal.
• S corporation status and IRC section 338(h)(10) election.
• Real estate investment trust (REIT) status.

Tax Balance Sheet Mitigation

Taxpayers can also benefit from tax insurance as a corporate risk management tool for contingent exposures. Tax insurance can step in as a time- and cost-efficient alternative to a letter ruling, providing a taxpayer with protection from exposure for a future challenge by a federal, state, or foreign taxing authority.

Common areas of coverage for balance sheet risk mitigation include the following:

• Internal tax planning and restructuring.
• Net operating loss (NOL) protection.
• Tax credits and recapture.
• Financing and capital arrangements within a multinational group.
• Debt/equity characterization.

Insurance buyers should understand that tax insurance policies cover specifically identified tax risks; they do not provide blanket coverage for unknown risks. Tax insurance is also not a means to promote aggressive tax schemes or facilitating tax shelters. Rather, it is intended to bring certainty to a transaction or tax planning strategy that is strongly supported but not entirely free from doubt.

Renewable Energy

In the United States, the successful financing of any renewable energy project—including solar, wind, biomass, carbon sequestration, and battery storage projects—typically is contingent on a project’s eligibility for federal investment tax credits and production tax credits. Where the facts and circumstances of a project don’t fit squarely within the scope of tax legislation and IRS guidance, renewable energy companies can use tax insurance to provide the protection that capital providers require.

Tax insurance can do the following:

• Mitigate structural risks to ensure that the allocation of tax and cash attributes will be respected.
• Provide financial relief in the event of a successful IRS challenge that the requirements for realizing anticipated investment or production tax credits are not met under the begun construction and continuity tests as set forth by IRS guidance.
• Manage appraisal-backed tax risks (for example, repowering and qualified basis) to provide relief in the event that the IRS does not respect the tax credits dependent on the appraised value.

Distressed Markets

Amid the COVID-19 pandemic, tax insurance can serve as a critical risk mitigation tool for owners or buyers of stressed or distressed companies and assets. Companies facing financial stress or distress may consider restructuring, raising new debt, modifying existing debt, seeking to access capital, and divesting assets.

Tax insurance can help facilitate such transactions and provide certainty around positions taken for the benefit of owners, buyers, lenders, and creditors. Coverage for distressed companies can, for example, provide benefits in regard to the following:

• Cancellation of debt and debt restructuring.
• Worthless stock deductions.
• NOL carryback and carryforward rules under the Coronavirus Aid, Relief, and Economic Security Act.
• IRC section 368(a)(1)(G) insolvency reorganizations.

Policy Basics

A tax insurance policy typically covers specifically identified federal, state, or foreign tax exposure, penalties, and interest. A policy also covers the gross-up of insurance proceeds if they’re expected to be taxed upon receipt, and contest costs (less retention) associated with the tax authority challenge. Policies typically include a one-time deductible—the amount of risk the policyholder retains—that ranges from $250,000 to $500,000; however, it can vary depending on facts and circumstances.

Policy pricing ranges between 2.5% and 5% of the limit of liability purchased, with the premium payable as a one-time lump sum at the inception of the policy. Pricing, however, can vary depending on case-specific factors—for example, the jurisdiction of the tax risk, the amount of risk retained by the insured, or the perceived strength of the tax opinion. In the United States, 16 insurers and managing general underwriters currently write tax insurance, translating to approximately $1.5 billion of available capacity for any one given tax risk.

The standard tax insurance policy term is seven years, which is meant to comfortably cover the statute of limitations period and any potential extensions. However, 10-year policies are available for forward-looking risks (for example, renewable energy tax credits).

Tax insurance is a “claims-made” policy. A claim is defined as a notification to the taxpayer by a taxing authority that a covered position is being investigated. A taxpayer is required to appeal the matter until a final determination is made in the applicable court (generally one appeal). In the event of a claim, the insured must provide notice and act in accordance with the terms of the policy. If a final determination is reached and a payment of a claim is required, the claim payment will be made by the insurer in a timely manner to prevent any liabilities for interest or penalties arising from late pay to the taxing authority.

Additional exclusions may apply depending on the nature of the tax risk, but tax insurance policies typically exclude coverage for losses caused by—

• inconsistent filing by the insured,
• settlement by the insured without insurer consent,
• material misrepresentation by the insured, and
• change in the applicable tax law.

Placing a Policy

The placement of a tax insurance policy can be completed in as little as one to two weeks. Some policies require more time, depending on the complexity of the exposures to be insured and the availability of relevant information.

In placing a policy, it’s important to work with the right broker—one that understands the critical tax risks for businesses and can help secure the most tailored and cost-effective solution. Choosing the right broker is also important because in the event of a loss, the broker can assist with communications between parties throughout the claims process.

The broker will work on a client’s behalf to place and negotiate a tax insurance policy that best addresses the specific tax risk and will prepare information for potential insurers, which is critical to obtaining competitive terms.

Generally, this documentation includes the following:

• A detailed description of the organization’s tax position and, if applicable, the proposed transaction structure.
• A description of the type, value, and timing of tax issues involved, including a computation or schedule of the tax benefits or the potential loss involved.
• A copy of the final or draft tax opinion or memorandum, if available.

If an insurer reviews this information and is comfortable with the risk, it will typically submit a nonbinding indication letter (NBIL) to the broker; this process generally takes three to five business days. All parties are subject to confidentiality agreements and nonreliance letters, at the request of the client. A client’s tax advisor is not held responsible for the advice; it’s simply a roadmap, and the underwriter will engage its own counsel to determine its position on the risk.

After the broker receives market feedback, the broker will provide its client with a quote summary outlining the scope of coverage—including key exclusions, limits, pricing, and retention—offered by each insurer. The broker will then advise the client and its counsel regarding the competing offerings and assist them in determining which underwriter to move forward with in the due diligence process.

There’s no cost to obtaining NBILs. If the client wishes to move forward, an underwriting fee is payable to help offset the underwriter’s cost for third-party advisors. The underwriting process and policy negotiation is generally completed in one to two weeks, with participation of the client, client’s counsel, the underwriter, and the underwriter’s counsel.

At the conclusion of policy negotiations, a binder is executed as proof of insurance until the final policy can be issued.

The Value of Tax Insurance

Whether you’re involved in an M&A transaction, developing a renewable project, or looking to de-risk your tax balance sheet, a bespoke tax insurance solution just might be the way to get your deal closed, project securely financed, or balance sheet risk mitigated. With a vibrant and competitive group of insurers actively looking to write U.S. risks and available coverage expanding to include foreign tax risk, now is the time to consider using this cost-effective solution to your benefit.

This article was written by specialists in Marsh’s Transactional Risk Practice, who have deep experience and expertise in taxation, corporate law, investment banking, and accounting policy. Our understanding of the critical risks faced after a transaction or with tax planning strategy, of transactional risk insurance markets, and of transactional risk claims, help us offer clients comprehensive and cost effective solutions.

Scott Brady is a managing director at Marsh and leads the private equity mergers & acquisitions (PEMA) practice in the East.  He and his PEMA colleagues oversee a wide range of private equity and corporate investor clients and assist them in the full range of M&A and transaction risk solutions that Marsh offers.  

Mark McTigue, CPA, MBA, is a senior vice president in the transactional risk practice at Marsh. He is a former tax advisor and investment banker who has worked on tax structuring solutions for over two decades. Mark has structured customized tax insurance solutions for clients of Marsh over the last 3.5 years.

Antony Joyce is a senior vice president in the transactional risk practice at Marsh. He has had a tax focus throughout his career in both an advisory capacity and in front-office structuring roles with global investment banks. At Marsh, Antony is focused on crafting cost effective tax insurance solutions to facilitate M&A activity, to aid the financing of renewable energy projects and to mitigate balance sheet tax exposure.

Alisha Soares, JD, is a senior vice president in the transactional risk practice at Marsh. She is focused on structuring customized tax insurance solutions. Prior to joining Marsh, Alisha was a tax advisor at Alvarez and Marsal and KPMG where she worked in their respective mergers and acquisitions practice. She earned her JD at New England Law Boston.